The Federal Reserve's attempt to lift inflation to a level thatwould reflect a healthier U.S. economy is starting to take hold inthe bond market.

For the first time in 19 months, investors are stepping up theirbuying of exchange-traded funds (ETFs) that hold Treasuries tied tocost-of-living increases, data compiled by Bloomberg show. At thesame time, inflation expectations over the next five yearssurpassed 2 percent to reach the highest level since May after agovernment report showed hourly earnings among U.S. workers jumpedmore on average in February than economists forecast.

The shift in bond-market perceptions shows that some investorsnow anticipate consumer demand in the world's largest economy willbe strong enough to push inflation toward the Fed's elusive 2percent target. Last year, investors were so convinced thepersistent lack of price pressure had become entrenched thatTreasury Inflation Protected Securities, or TIPS, posted theirworst losses since they were introduced in 1997.

“Inflation is coming,” Michael Pond, the head of globalinflation-linked research at Barclays Plc, one of the 22 primarydealers that trade with the Fed, said in a telephone interview fromNew York. We're starting to break “free from some of thedeflationary shackles of last year. The labor market is picking up,which will cause wages to pick up.”

While a recovery in consumer spending would validate the Fed'smove to scale back its quantitative easing (QE) after flooding theU.S. economy with more than $3 trillion since the financial crisis,the risk of inflation has prompted some investors to favor TIPSover Treasuries that pay a fixed rate of interest.

Unlike Treasuries, whose fixed payments lose value as livingcosts increase, TIPS appreciate. The securities returned 2.75percent this year, rebounding from a 9.4 percent plunge in 2013 andoutperforming the broader market for U.S. government debt, indexdata compiled by Bank of America Merrill Lynch show.

Many investors have been overly optimistic that “inflation willstay relatively contained and that the Fed will make a gracefulexit from QE,” Zach Pandl, a senior interest-rate strategist atColumbia Management Investment Advisers, which oversees $340billion, said by telephone from Minneapolis. “The economy has madea lot of progress and is accelerating.”

Pandl, who is avoiding Treasuries because of the likelihood theeconomy will strengthen, is buying TIPS. Yields on the benchmark10-year TIPS have fallen 0.31 percentage point this year to 0.49percent, while those on similar-maturity Treasuries have declinedto 2.68 percent from a more than two-year high of 3.03 percent onDec. 31.

Inflation Rising for Three Straight Months

Net purchases of the 12 ETFs that hold U.S. inflation-linkedbonds have totaled $399 million in March, the first time sinceAugust 2012 that combined inflows have surpassed redemptions fromthe funds, data compiled by Bloomberg show.

The largest such ETF, the $13 billion iShares TIPS ETF run byBlackRock Inc., is poised to snap its longest streak of withdrawalssince its inception a decade ago with the biggest monthly netincrease in two years, the data show.

Inflation expectations have picked up on signs that wage growthwill lead to more consumer spending. The gap between yields onfive-year Treasuries and similar-maturity TIPS widened to a10-month high on March 7, implying that consumer prices will risean average 2.01 percent over that span.

As recently as June, the break-even inflation rate was 1.63percent, the lowest since January 2012. It was at 1.95 percent asof 2:08 p.m. in New York.

Average hourly earnings for all U.S. workers climbed by 9 cents,or 0.4 percent, to $24.31 last month, according to the LaborDepartment, the biggest gain since June.

Employers added more workers than forecasters estimated, a signthe U.S. economy is starting to shake off the effects of severewinter weather that slowed growth at the start of 2014.

The Obama administration is also calling on Congress to raisethe federal minimum wage by almost 40 percent, to $10.10 an hour,over the next three years, which may boost the ability of thelowest wage earners to buy more goods and services.

“Inflation may move up higher than people think,” David Leduc,the chief investment officer at Standish Mellon Asset ManagementCo., which manages $160 billion, said in a telephone interview.This month the Boston-based firm began buying TIPS with maturitiesas long as five years, he said.

After falling to a four-year low of 1 percent in October, theannual inflation rate has risen for three straight months to reach1.6 percent in January, data compiled by Bloomberg show. Economistsin a Bloomberg survey anticipate the cost of living will rise 1.7percent this year and 2 percent in 2015.

Stagnant Incomes Keep Inflation in Check

It's still too soon to start worrying about inflation becausestagnant incomes will keep consumer spending in check, according toJennifer Vail, head of fixed-income research of theMinneapolis-based U.S. Bank Wealth Management, which oversees $112billion. Disinflation, or a slowdown in price gains, is instead themore immediate threat to the economy, she said.

Incomes in the U.S. have increased an average 2.1 percent overthe five years since the financial crisis, less than the 3.3percent growth during the previous decade, according to datacompiled by Bloomberg.

The Fed's preferred gauge of inflation, known as the personalconsumption expenditures deflator, has been below the centralbank's 2 percent goal for 21 straight months and rose just 1.2percent in January from a year earlier. In the past year, the indexhas fallen below 1 percent three times and has never exceeded 1.5percent. The last time inflation based on the Fed's measure was solow during an expansion was in 1998.

Bond-market expectations for consumer prices in the latter halfof the coming decade, another measure used by the Fed called thefive-year, five-year forward break-even rate, has declined to 2.41percent, the lowest since July.

“The Fed is still much more concerned with disinflation rightnow, and it's a valid concern,” Vail said by telephone. “Willinflation rise eventually? Yes, but no time soon.”

More jobs, higher home values and record stock prices arehelping to give consumers more reasons to spend, according toWilmer Stith, a Baltimore-based money manager at Wilmington TrustInvestment Managers, a unit of Wilmington Trust, which oversees $79billion.

Household wealth in the U.S. increased by $2.95 trillion lastquarter to a record $80.7 trillion, data compiled by the Fed show.Last month, retail sales increased for the first time in threemonths, according to the Commerce Department, a sign the harshweather that curtailed spending is abating.

'Half-Full' Glass for TIPS

Consumer spending is one reason why economists are anticipatingfaster growth. They predict the U.S. economy will expand 2.7percent this year and accelerate 3 percent in 2015, which would bethe fastest in a decade, data compiled by Bloomberg show. Lastyear, the economy grew 1.9 percent.

While the strength of the U.S. economy has prompted economiststo predict the Fed will continue to pare its monthly bond buying by$10 billion each month until ending its stimulus by year-end, thepurchases will ultimately help to spur prices and buoy demand forinflation protection, Stith said.

“All of a sudden it seems the glass is half-full instead ofhalf-empty for TIPS,” Stith, who has been boosting his TIPSholdings, said by telephone. “There is upward pressure on wages andthe Fed, while tapering, is still expanding its balance sheet,increasing the prospects of inflation.”

Inflation has already emerged across financial markets, withbond yields moving inversely to stock prices for the first timesince 2007, according to Jim Paulsen, Minneapolis-based chiefinvestment strategist at Wells Capital Management.

Signs of price pressures may also be lurking in short-termunemployment data. The jobless rate for Americans who have been outof work less than 27 weeks was just 4.2 percent last month. That'sclose to the lowest since April 2008, and it's 0.6 percentage pointbelow the average since 1948, Labor Department data show.

The depressed level suggests the U.S. labor market istightening, raising the odds a pickup in wages will eventually leadto faster inflation, according to Michelle Girard, chief U.S.economist at RBS Securities Inc. in Stamford, Connecticut.

For bond investors, the latent risk means they should be buyingTIPS now, said Matt Freund, chief investment officer of USAA MutualFunds, who oversees more than $60 billion.

“Every day the potential for inflation grows,” Freund said in atelephone interview from San Antonio, Texas. “Once people areworried about inflation, it's too late.”

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